A Free-Market Energy Blog

Ronald Coase and Business Understanding (Part I: Why Are There Firms?)

By Robert Bradley Jr. -- September 5, 2013

[Editor note: Ronald Coase died last week at age 102 (obits here and here). One of the most important economists of the last century, Coase substituted real-world economics for ‘blackboard economics’ to solve some fundamental questions–and to appreciate market processes in place of government intervention.]

“When economists find that they are unable to analyze what is happening in the real world, they invent an imaginary world which they are capable of handling. It was not a procedure I wanted to follow in the 1930s. It explains why I tried to find the reason for the existence of the firm in factories and offices rather than in the writings of economists, which I irreverently labeled as ‘bilge.’” (Ronald Coase)

MasterResource attempts to comprehend markets and government regulation of markets. Undesigned (market) order is compared and contrasted to imposed (government) disorder.

As such, the performance of firms and industries within the oil, gas, and electricity markets is studied. Some firms are integrated between segments (upstream, midstream, downstream); others compete as nonintegrated independents in a particular segment.

And let history note that most government intervention in energy markets has come from independents seeking stability against integrated rivals [Oil, Gas, and Government: The U.S. Experience, pp. 1795–1800; 1851–52].

But why are there firms instead of everyone acting independently at arm’s length? And, as discuss in Part II, if central organization works within the firm, why not in a whole economy? These questions were posed, studied, and solved by Ronald Coase.

Here is my attempt to explain the subtle but profound contribution of Coase in a you-were-him fashion (we can all pretend to be so smart, can’t we?). It is taken from chapter 4 of my Capitalism at Work: Business, Government, and Energy (pp. 113–16).

Economics has long studied the behavior of firms. But the firm itself was assumed rather than explained—a “rhetorical device” depicted by a few cost and revenue curves on a page or blackboard. The firm was defined as a collection of resources under a common management that transformed inputs into outputs. Firms grew with profits and contracted with losses; firms had become bigger and less localized with falling transportation costs; and firms had become more specialized in response to a growing division of labor. Economists also recognized how entrepreneurs and managers sought to uncover—department by department, product by product, person by person—the money-makers and money-losers in order to initiate change.

But why does a firm exist in the first place? Why do people band together in one enterprise rather than work separately, each selling his services to the other in the arm’s-length marketplace? Relatedly, what determines the boundaries of a firm? Why are some firms big and others small, some firms integrated and others not? An inquiring young mind would formulate the right questions and find the answer.

Ronald Coase (1910–2013) entered the London School of Economics in 1929 to pursue a business degree. In his second year, he attended a seminar taught by Arnold Plant, a “commonsense” economist who specialized in business. There, Coase was introduced to Adam Smith’s notion of the invisible hand. “[Plant] explained that the economic system was coordinated by the pricing system,” remembered Coase. “I was a socialist at the time, and all this was news to me.” The seminar on industrial organization discussed why firms expanded horizontally (buying a competitor) or vertically (buying a supplier for, or purchaser of, its own products).

Coase was puzzled. Markets worked and socialism did not because of the prerequisite of competitive pricing to perform economic calculation. Yet the firm (“that little planned society”) was outside of the price system (open market) as defined by arm’s-length transactions. Corporations seemed to be getting bigger and bigger, and Lenin had talked about Russia as One Big Factory. How did all this square?

To find out, Coase traveled to the United States in 1931/32 on fellowship. It was an active, productive venture, although his destination was in the throes of the Great Depression. Coase visited many leading companies—Allis Chalmers, Ford Motor, General Motors, Montgomery Ward, Sears Roebuck, and Union Carbide, among others.

Coase quizzed leading economists and even happened upon classes taught by Frank Knight at the University of Chicago. Coase sought answers from the socialist candidate for president of the United States, Norman Thomas. He read books on business organization, including studies by the Federal Trade Commission. He studied the business directory in the cities he visited, fascinated by the division of companies within each industry. All this effort was much better than reading the “absolute bilge” in the economics journals, Coase remembered.[1]

It took innumerable queries and worn-out shoes, but Coase found his answer. “I was then twenty-one years of age and the sun never ceased to shine,” Coase would tell a gathering in Stockholm, Sweden, in December 1991. “I could never have imagined that these ideas would become some 60 years later a major justification for the award of a Nobel Prize.”

Coase’s theory, which he had formulated to his satisfaction in 1934, was published as “The Nature of the Firm” in Economica three years later. “The main reason why it is profitable to establish a firm would seem to be that there is a cost of using the price mechanism,” Coase famously stated. But what did this mean, exactly.

A firm exists, he explained, because it is cheaper to work collectively under a few broad rules and open-ended contracts than it would be for the employees to split apart, rely on arm’s length agreements, and get the same business done (“using the price mechanism”).

Compared to the “you’re hired” handshake and working alongside one another, pursuant to a general understanding regarding salary, budget, and office norms, individuals-qua-firms would have to spend more time negotiating and renegotiating arm’s length contracts, inspecting performance, and resolving disputes. Knocking on the door of an officemate is easier than more formal communications to get expectations realigned or a contract amended.

“The operation of a market costs something, and by forming an organization and allowing some authority (an ‘entrepreneur’) to direct the resources, certain marketing costs are saved,” Coase noticed. “It is true that contracts are not eliminated when there is a firm but they are greatly reduced.” Coase’s marketing costs—the costs of arranging economic activity—would come to be called transaction, information, or friction costs, terms that every business and economics student learns today.

Organizational theory, building on Coase, recognizes the role of nonprice planning in a firm and the competitive advantage gained from, in Edith Penrose’s words, “the cumulative growth of knowledge, in the context of a purposive firm.”

Coase’s breakthrough allowed him to understand the boundaries of the firm. The entrepreneur uses economic calculation (money prices) to assess the costs and benefits of adding or subtracting a function (or resource, given a function). The question is always, should the function be done inside the firm or purchased on the market? The more often the economic calculation is made to perform the activity internally, the larger the firm (and vice versa), other things being equal.[2]

“I have made no innovations in high theory,” Coase humbly began his Nobel acceptance speech. But Coase was immersed in high theory with his concept of marketing costs, which unlocked the nature of the firm and led to whole new ways of thinking. Yet Coase distanced himself from mainstream economics, since microeconomics was mired in the equilibrium-always, perfect-knowledge world, where information costs were zero and firms were frozen.

Not being formally trained in economics was a blessing. “I started . . .  with an education in commerce,” recalled Coase, so “when I began to study economics it was with a view to using it to understand what happened in the real world.” Still, in time, Coase’s contribution would become core to economics, complementing the work of Joseph Schumpeter, Frank Knight, and Ludwig von Mises in understanding the nature of capitalist enterprise.

Enron’s Misinterpretation

Ronald Coase’s theory of the firm was a driver at Enron.[3] While Ken Lay’s business model was broadly Schumpeterian, Jeff Skilling’s model was specifically Coasian. Enron’s wholesale marketing operation, encompassing hundreds of products, mostly in gas and electricity, but also pulp and paper, steel, water, and broadband, went online in late 1999. EnronOnline soon became a leading business-to-business offering on the Internet, just as Amazon.com became the leading business-to-consumer retailer.

Skilling pronounced the coming end of the integrated oil company, given the radical reduction of transaction costs provided by the new medium. “You will see the collapse and demise of the integrated energy companies around the world,” he said. “They are going to break up into thousands and thousands of pieces.”

At a minimum, Skilling believed, an ExxonMobil or Chevron would pick its most preferred activity—say refining—and sell its assets in exploration and production, transportation, and wholesaling to other parties, and then turn to the Internet to deliver the whole product to its name-brand dealers.

Enron would declare bankruptcy about one year after then-CEO Skilling gave this speech at Arthur Andersen’s Energy Symposium 2000. Ken Lay would be back as CEO of Enron, reassuming the title he had awarded to Skilling six months before.

Obviously, there was a great disconnect between Coase’s unassailable theory and the business model Skilling based on it. Disequilibrium economics explained, but certainly did not financially insulate, uncertainty-bearing entrepreneurship.

The divergence between theory and practice can be explained by poor execution and the high capital costs of backing up paper trading with physical assets to ensure performance (or really ensure backup in case of nonperformance).


[1] “When economists find that they are unable to analyze what is happening in the real world,” Coase explained, “they invent an imaginary world which they are capable of handling. It was not a procedure I wanted to follow in the 1930s. It explains why I tried to find the reason for the existence of the firm in factories and offices rather than in the writings of economists, which I irreverently labeled as ‘bilge.’”

[2] Also see the Internet appendix 4.7, “Markets within a Firm,” at www.PoliticalCapitalism.org/Book1/Chapter4/Appendix7.html.

[3] The zero transaction cost assumption (just the opposite of the real world described by Coase) drove electricity restructuring in California, a policy decision that contributed to the crisis of 2000/2001.

One Comment for “Ronald Coase and Business Understanding (Part I: Why Are There Firms?)”

  1. Kermit  

    Quite interesting and definitely sound reasoning by Coase. Personally, in the type of business I am in, telephones, fax machines and now internet are key to collaboration among small entities to source supplies for the end user. In a sense, friendly competitors often functions as a firm.


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